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January 3, 2012

The Case for Emerging Market Equities in Client Portfolios

By definition, a due diligence consultant considers the investment merits of various asset classes and diversification strategies. For Prima Capital it is a continual process, especially because advisors today have increasing access to solid portfolio diversifiers like floating-rate loans, alternatives, and international fixed income—investments that go well beyond the conventional stock, bond, and cash categories. All of these not-so-traditional asset classes rise and fall on their own investment merits and all can enhance the overall potential of a portfolio. Emerging markets equity is currently a popular destination for assets, and not without reason.

No Time for Home-Country Bias

It’s a well-documented reality that certain investors exhibit a natural tendency toward investments in domestic markets. They tend to hold optimistic expectations about the domestic market and are either pessimistic or indifferent about foreign markets. This ‘home country bias’ limits many investors’ utilization of emerging markets in their portfolios.

We suggest this is a very good time for these folks to get past that predisposition. Why? Because beyond their quantifiable diversification benefits, emerging market assets are poised to benefit from the expected economic growth in the underlying countries. Stocks in these regions remain highly sensitive to drops in risk appetites, of course—2011’s third quarter, for example—but we think an institutional-grade asset allocation strategy should consider a commitment to the space.

From a portfolio construction perspective, both the relatively low R-squared of emerging market equities and the category’s historical performance are both highly attractive attributes. As for the diversification benefits of the asset class, over the last 10 years the rolling three-year R-squared between the Russell Emerging Markets Large Cap Index and the S&P 500 has averaged 0.69. From a performance perspective, Prima’s research found that an investor with a 60/40 allocation to the S&P 500 Index and the Barclays Aggregate Index over the last 10 years would have picked up 42% in performance and a marginally higher Sharpe Ratio by simply substituting 20% of the S&P 500 allocation with the Russell Emerging Markets Large Cap Index.

What About EM Investing in the Future?

As attractive as these historical statistics are, a forward-looking assessment of the regions’ economic fundamentals may be even more relevant and convincing. Most of the portfolio managers we speak with believe that a combination of favorable demographic trends, increased urbanization, and the rise of the

middle class in the emerging markets will result in economic growth that will far outpace that of the developed world.

In an investment context, that means that an investor who only allocates capital to advanced economies will be limited to regions marked by relatively low growth prospects. How low? According to estimates by the International Monetary Fund (see chart on left), the GDP growth rates of emerging economies will be nearly three times those of the advanced economies over the next several years.

Further, and as a direct result of this growth, the IMF projects that emerging economies will actually surpass the cumulative value of advanced economies and become a majority of global GDP by 2013,

as measured by Purchasing Power Parity, or PPP (see chart on left).

The message of these data points is clear: It is becoming increasingly difficult to overlook this asset class when advising a long-term investor.

Meanwhile, in light of the European debt crisis and the increasingly disconcerting debt calamity in the

United States, advisors are focusing more on sovereign balance sheets and their implications for local markets. Here, too, emerging economies possess a significant structural advantage over advanced economies, as they collectively possess considerably lower debt-to-GDP ratios (see chart below).

Worth the Effort

All of this said, we can’t ignore the hurdles investors, including portfolio managers, face when allocating to developing markets. Valuations, which fluctuate widely alongside prices, can make the entry point for short-term investors difficult, particularly when the asset class is in vogue and selling at rich premiums. (At the moment, we estimate valuations to be within long-term averages following the downturn in Q3 of 2011.) Volatility, too, is more extreme. For the 10-year period ending in Q3 of 2011, standard deviation for the Russell Emerging Markets Large Cap index was 24.67%, a good deal greater than the 16.93% figure for the Russell Developed Large Cap (according to Morningstar and Prima Capital’s research). Limited financial transparency can also be problematic for the asset class at times. Though this issue has been headed in the right direction over the last decade, the occasional governance/political flareup, like Hugo Chavez’s nationalization efforts in Venezuela last year, remains a risk.

Given these complications, and recognizing the regional emphasis of various emerging market approaches, it’s not too surprising that the performance dispersion amongst portfolio managers in this space is high. Prima’s analysis of 580 emerging markets equity managers in the Morningstar database reveals a 13.6% differential in three-year annualized return between the top-decile and bottom-decile manager. Even more striking was the range we found for three-year annualized returns: 8.2% to 38.1%.[1] Clearly, these wide performance spreads present a challenge for any manager search and selection process. At the same time, the numbers are a reminder of the great potential for alpha generation in emerging markets, both on a relative and absolute basis.

Bottom line, emerging markets equities have provided investors with favorable performance and solid diversification benefits over the last 10 years, the outlook for the underlying economies is relatively attractive, and there are a good number of portfolio managers who can capture these benefits. In our view, all of this presents a strong case for the inclusion of the emerging market equity asset class into a portfolio.

Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.